Thursday, December 14, 2006

Merrill Lynch, 14 December 2006; The following is the first 2 pages from the report

Economic growth likely to slow

Our forecast of a marked slowing in US consumer spending growth dominantly accounts for our projected decline in Canadian overall GDP growth from the 3.0% average over the past three years to 2.1% in 2007. The channel through which that weaker US demand is likely to hit Canadian growth is the auto-heavy, export oriented manufacturing sector.

Bank earnings growth likely to slow

We expect 8% earnings growth next year. We do not believe that 2007 will be as accommodating for the banks’ earnings as the last five years, for two main reasons. Banks’ provisions for credit losses as a percentage of loans have declined 79% over that period, and are at the very least likely to flat line. Equity markets have appreciated by 18% per year in Canada in the last four years and 15% in the US. Those growth rates are clearly unsustainable over extended periods.

Valuations are high by historical standards

Canadian banks are trading at valuations that exceed their five year average. Banks have garnered this valuation as they appear much less exposed to the expected slowdown in the US consumer than US financials or the energy and materials sectors, which make up 44.3% of the S&P/TSX Composite Index, versus 31.7% for financials.

TD is our only Buy-rated bank

We rate TD a Buy and have a 12-month price objective of $74. TD trades at 12.6 times 2007 estimated earnings per share, compared to 13.1 times for the other Big 6 banks, in spite of having the highest outlook for earnings growth in 2007 and 2008, in our view, and lessened acquisition risk. We believe TD can achieve above-average earnings growth on TD Ameritrade synergies, increased TD Banknorth and TD Ameritrade ownership, better retail banking momentum in Canada and lesser credit risk. Our $74 price objective assumes a stable P/E multiple, which is in contrast to the multiple compression we expect for the rest of the industry.

Q4/06 earnings above expectations

Canadian bank earnings were ahead of our expectations, driven by strong loan growth, relatively stable margins and core tax rates that were well below sustainable levels. CIBC and Royal Bank were most ahead of our estimates, and consensus, while Scotiabank and TD Bank fell short of expectations.

• CIBC beat via better results from retail banking and wealth management as well as a lower than expected tax rate compared to our overly high estimate. (Exhibit 2) Lower retail PCLs – which were 25% below the average of the last four quarters – drove the good results, as revenue growth was the lowest of the group. The bank’s initiatives to reduce unsecured consumer loan losses are paying off more rapidly than we had anticipated.

• Royal Bank experienced broad-based revenue growth during the quarter which, combined with a low tax rate, led to the earnings beat. The higher earnings came in spite of an increase in the bank’s PCLs – which were 49% above the average of the last four quarters. Capital markets revenue were well ahead of our estimate as higher M&A revenue in Canada, higher private equity gains and stronger US debt origination offset the (expected) decline in trading revenue and lower securities gains.

• Bank of Montreal surpassed expectations on what we believe to be lower quality sources of earnings – namely a low tax rate and continued low PCLs. The tax rate of 18% compared to an average of 28% in the previous four quarters, while annualized specific PCLs were 71% below the average rate of last 15 years. Trading revenues were 55% below the average of the last four quarters and should provide a partial offset going into 2007 versus the other, lower quality, earnings sources.

• National Bank also exceeded our expectations on relatively low quality sources of earnings. The financial markets division accounted for all the difference as both trading revenues and securities gains were high versus normalized levels. On a consolidated basis, securities gains were 47% ahead of the 4-quarter average while trading revenues were 39% ahead. Wealth management was below our estimates on higher expenses.

• TD Bank’s fourth quarter earnings met our expectations, but the quality was low, in our view, as the tax rate of 18% was 6% below our forecast. Domestic retail banking earnings were light by 5%, mainly due to surprisingly high PCLs, but also higher expenses. PCLs grew to $132 million versus $104 million in Q3/06 and $78 million in Q2/06 on rapid credit card growth and lower commercial reversals and recoveries.

• Scotiabank’s results were most-below our expectations, as the bank’s low tax rate was not enough to offset weakness in its core divisions. On an aggregate basis, revenues were light versus our expectations (because of the Other division), expenses were higher (Domestic and International) and the tax rate was low (18% versus the 20-23% expected range, driven by the Other division). Higher PCLs in Scotia Capital more than offset lower PCLs in Domestic Banking and International, and led to an overall level of PCLs 39% above the average of the last four quarters.